The words benchmark and index are often used as synonyms in the financial language. Generally speaking, this seems to be right, but there are some differences between an index and a benchmark that every investor needs to know, since a benchmark is not necessarily the same as an index.
An index, especially for securities markets, is a key figure that expresses the development of the prices for the respective securities over time. With regard to this, it indicates the basic trend in a capital market. This means an index serves as an indicator of the state of a market or the economy as a whole. Indices can be split into two categories, general indices and sector/themed indices.
The definition and, therefore, the purpose of an index is based on the primary objective of the developer. That said, not every index has been designed to be used as benchmark. In fact, the most prominent indices (S&P 500, Nikkei 225, Dow Jones Industrial, CAC 40, etc.) were introduced as indicators for the state of the market and were not developed for any investment purpose.
Nevertheless, these indices are nowadays used as benchmarks or underlying for financial futures and other derivatives despite some shortcomings.
That said, an index can be the basis for performance analyses and comparisons of the results achieved in a specific market with the market, and can therefore be used as a benchmark.
Requirements of a benchmark
Benchmarks serve as yardsticks for measuring the success of a portfolio relative to the underlying markets. As mentioned above, in many cases market indices are used as benchmarks, while in other cases indices are constructed for this purpose.
Benchmarks need to meet various requirements to become meaningful for investors:
- The investor and the portfolio manager need to be aware of the benchmark prior to any investment decisions.
- The comparability between the portfolio and the benchmark needs to be assured by adhering to the same restrictions. This means the benchmark should reflect the strategic asset allocation defined by the investor.
- The benchmark needs to be investable. If this criterion is not met, it is not possible to replicate the benchmark in terms of its risk/return profile.
- It should be possible to buy the constituents of the benchmark in a cost-efficient manner to ensure that passive management is a viable alternative for the investor.
More generally speaking, a benchmark should take the individual goals and the risk bearing capacity of an investor into consideration. At the same time, it should be possible to buy the constituents of the benchmark in a cost-efficient manner (either as ETF or as future) to ensure that the portfolio manager can be challenged by using passive products. In addition, it is common sense that benchmarks should in general be broadly diversified to avoid concentration risks. That said, we witnessed during the long bull market and the rise of the so-called Magnificent Seven that even broad diversified indices like the S&P 500 can bear concentration risks.
To answer the question from the headline, an index is an indicator for the trend in a given market (segment) or an economy and can be used as benchmark, if it fulfils the respective criteria. Conversely, a benchmark is designed to measure the success of an individual portfolio relative to its underlying markets. That said, the composition and performance of an index is normally available to the public (subscription fees may apply for this information), while the composition and performance of a benchmark created for an individual investor is only available to the investor and the respective portfolio manager.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of Lipper or LSEG.
